The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Sunday, June 2, 2013

As Sir Mervyn King ends his term as Governor of the Bank of England, he has offered up some reflections on the ongoing financial crisis.

Each reflection is further confirmation that banks must be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with ultra transparency that market participants are no longer reliant on financial regulators and institutions like the Bank of England to both assess the level of risk at the individual banks or financial system as a whole and to accurately communicate this risk to the market. Note, these guardians of the financial system will never accurately communicate risk to the market for fear about damaging the safety and soundness of the financial system.

Sir Mervyn King confessed on Desert Island Discs on Sunday that he slept soundly during the events that sent the economy spiralling into recession but was surprised it had taken the public so long to react angrily to the way the banks had behaved and were responsible for the crisis....

Perhaps the UK public has taken a long time to react angrily with the banks, but the US public has been reacting angrily since the beginning of the financial crisis. As President Obama put it, he was standing between the bankers and the lynch mob.

While Sir Mervyn King slept soundly, I wonder if the same could be said of Fed Chairman Ben Bernanke. When he testified before Congress on the need for TARP, he looked pale as a ghost.

Sir Mervyn acknowledged that the Bank had failed to either detect or diagnose the extent of the crisis and were in the dark about the time bombs sitting in bank balance sheets.

Please re-read the highlighted text as Sir Mervyn has just put forward the strongest case possible for requiring the banks to provide ultra transparency.

As regular readers know, under the FDR Framework, it is the responsibility of government to ensure that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

For banks, this information is only provided when they provide ultra transparency into their current global asset, liability and off-balance sheet exposure details.

With this disclosure, the Bank of England might still have failed to either detect or diagnose the extent of the crisis, but it would not have subsequently been in the dark about the time bombs still sitting on bank balance sheets.

More importantly, with this disclosure, under the FDR Framework, each market participant under the principle of caveat emptor (buyer beware) would be responsible for losses on their exposures to each bank.

Even if the investors failed to detect or diagnose the extent of the crisis, each investor had an incentive to limit their investment exposure to each bank to what they could afford to lose given their independent assessment of the risk of each bank.

By limiting their exposures to what they could afford to lose, the investors would have stopped the policy makers and financial regulators' irresistible urge to use taxpayer money to bail-out the banks. Instead, the unsecured creditors and equity holders of the banks would have suffered losses.

He rejected interviewer Kirsty Young’s suggestion he was guilty of being “too academic” in his approach to the issues and said the general feeling at the time among informed opinion makers and the press was that “we had a wonderful system.”

He added: “No-one realised it was going to go wrong so quickly.”

We do have a wonderful system based on the FDR Framework. It didn't go wrong quickly. It worked flawlessly for several decades.

When the system failed, it failed because the financial regulators with the responsibility for ensuring transparency allowed massive parts of the financial system to become opaque. Included in the opaque corners of the financial system were banks (what the BoE's Andrew Haldane calls 'black boxes') and structured finance securities (what the market calls opaque, toxic securities).

Fixing the financial system and ending the financial crisis has always been a straightforward task. The starting point is bringing transparency back to all the opaque corners of the financial system.

Unfortunately, leading the fight to maintain opacity are the very government institutions that are given responsibility for ensuring transparency in the financial system. Included on this list is the Bank of England.

He took issue with comments from a former member of the Bank’s Monetary Policy Committee, David Blanchflower, that as a highly paid executive he should have been aware of a developing crisis.

Your humble blogger cannot emphasize enough that under the FDR Framework our financial system is designed not to be dependent on any one person or entity being aware of a developing crisis.

Instead, our financial system is built on the combination of the philosophy of disclosure and the principle of caveat emptor. Everyone is given both the information they need and the incentive to protect themselves.

As Nassim Taleb would say, our financial system is "anti-fragile" by design.

It only became fragile when the government institutions responsible for ensuring transparency failed to do so.

“Anyone who says we know what’s going to happen is a charlatan,” he retorted....

There is a large difference between saying, like your humble blogger did in late 2007, that we are in a downward economic spiral that will only end when transparency is brought to all the opaque parts of the financial system and saying that tomorrow XYZ will happen.

The former is a statement of fact about the current state of our economy and financial system. The latter is in the realm of tarot card readers.

The Governor accepted that the last five years had not produced the legacy he wanted to leave behind. There were signs of recovery “but not as fast as we thought”.

If Japan has shown anything, it is that pursuing the same flawed economic policies as Japan did when its credit bubble burst nothing beyond lost decades will occur quickly.

Asked if there had been any moments that had caused him sleepless nights, he said: “I don’t think anything kept me awake at night because my training, my reading of financial history, meant I knew exactly what we had to do.”

Decisions like rescuing Royal Bank of Scotland were “quite easy” because it was obvious what had to be done, he added.

With this comment, Sir Mervyn completely discredits training as an economist as being fit for the role as head of a central bank. Clearly, training as an economist does not prepare one to assess the risk of a bank or know how to deal with a bank solvency led financial crisis.

As your humble blogger has repeatedly pointed out, the choice of pursuing the Japanese Model and protecting bank book capital levels and banker bonuses at all costs was wrong at the beginning of the financial crisis and it is still wrong today.

The lesson of history is the way to deal with and end a bank solvency crisis with minimum damage to the real economy or the social contract is to adopt the Swedish Model and require the banks to absorb upfront their losses on the excess public and private debt in the financial system.

The decision to bailout the banks using taxpayer money is irresistible to policymakers, central bankers and financial regulators. The only way to take this option off the table is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants know they are responsible for all losses on their exposures as they can independently assess the risk of each bank and adjust their exposure to what they can afford to lose given the risk of each bank.

What this does is links the risk each bank takes with its cost of funds. As a result, banks are subject to market discipline and are restrained in their risk taking.

Asked about his comment on August 8, 2007, the day before the credit crunch struck, that “the banking system is much more resilient than it was in the past”, he said: “Clearly it wasn’t... I think we learned that that was not true.”

This comment further confirms that training as an economist means knowing nothing about how a modern banking system is designed.

By design, banks are resilient.

In fact, banks are capable of absorbing all the losses on the excess public and private debt in the financial system and continuing to operate and support the real economy.

How are banks able to do this when they could have negative book capital levels after absorbing the losses?

The combination of deposit insurance and access to central bank funding makes this possible. With deposit insurance, the taxpayers become the banks' silent equity partners when they have low or negative book capital levels.

Please note, banks are designed so that the only time they need to be resolved is when their interest income is no longer greater than their interest expense plus their operating expenses.

So long as interest income is greater than interest expense plus operating expenses, banks are able to generate earnings that can be retained to rebuild their book capital levels.

I realize that rebuilding book capital levels after absorbing losses will be devastating to banker cash bonuses, but they really don't deserve cash bonuses when their banks lose massive amount of capital.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.